Financial talking heads may say the VIX
is low. So the market is due for a selloff. Or
the VIX is high and the market is going to
bounce. If it doesn’t happen their way, they
blame vol.

In point of fact, vol doesn’t reliably
predict market direction. Sometimes the
market crashes when the VIX is low. Sometimes the market rallies after the VIX spikes
higher—but not all the time. That inconsistency makes the VIX a not-so-great directional indicator, which leads some traders
to suggest the VIX is useless. And that’s just
plain wrong.

The VIX may help you choose a strategy
once you’ve determined your bullish, bearish, or neutral market opinion. Remember:
the VIX is just a measure of the implied vols
and, by extension, the extrinsic values of SPX
options. When vol is relatively low, it means
the extrinsic value of SPX options is relatively low, too. If you’re bearish, for example,
and VIX is low, you may decide to choose
a strategy that benefits from low extrinsic
values, like a long put vertical or a long put
calendar spread. If you’re bearish and VIX is
high, you may decide on a strategy that takes
advantage of the higher extrinsic values, like
a short OTM call vertical.

Those strategies are bearish. But each
tries to take advantage of how high or low
the extrinsic values of options might be.

Whether the VIX at 17 or 25 is consideredhigh or low, as a trader, you’ll still need tomake a judgment call. But use that judgmentto inform your strategy,not your directional bias.

That’s how you potentially
derive value from the VIX,
which can move rapidly and
because of that, can quickly
move against a position.

The VIX itself is never “wrong.” Saying the
VIX is wrong is like saying SPX options
prices are wrong. And that statement can be
tough, if not impossible, to prove. Above all,
it’s how you interpret VIX that matters. It
might indicate over-complacency in market
participants on one hand, or too much fear
on the other. Keep in mind the VIX is not
taking the pulse of the market. It’s taking
the pulse of market participants. Are traders
complacent or fearful? If traders expect a
quiet market, they may sell SPX options and
push prices lower. The VIX goes down, indicating complacency. If traders expect drama,
they may buy SPX options and drive prices
higher. The VIX goes up, indicating some
measure of fear or uncertainty. The VIX tells
you what the people trading the markets are
thinking. Do you want to join them, or not?

As a trader, what’s key is your judgment
as to how you’ll respond to movements in
the VIX.

Strictly speaking, the VIX index represents
only SPX options. But the thinkorswim®
platform from TD Ameritrade also has a
Vol Index that displays similar information
on any stock or index with options. Find it
on the Watchlist gadget (Figure 1). The Vol
Index uses the same type of formula as the
VIX, so you may interpret it in much the
same way.

Beyond our myth-busting, consider this
bonus fact! VIX options aren’t based on the
VIX; they’re based on /VX futures.

Before the cool kids start bad-mouthing
VIX options, let’s head them off with some
facts about how they’re priced. When you
look at VIX options and compare them to
the VIX’s price, a put with a strike that’s,
say, two points below the VIX looks less
expensive than a call that’s two points above
the VIX. Why?

A key concept in option pricing suggests
options are priced off their hedge. Stock
options are hedged with their stocks and
are priced off the stock’s price. But the VIX
itself is a cash index that isn’t tradable. If
you’re trading VIX options, what’s your
hedge? VIX market makers use /VX VIX
futures—specifically the /VX future that
expires at the same time as the VIX options.

If you type in the root futures symbol
/VX in the Trade page of the thinkorswim
platform, you’ll see all the /VX futures,
along with their days to expiration. You
won’t see any VIX options listed. And if
you type in VIX, you’ll see VIX options, but
not futures. But if you note the price of a
particular /VX future, say the September
/VXU8, and compare it to the Sep VIX
options, suddenly the VIX option prices
make sense. The call and put at the strike
closest to the price of the /VX future will
have roughly the same price. The intrinsic
value of the in-the-money (ITM) calls and
puts will match the difference between the
strike price and /VX future’s price. And the
OTM options will make a lot more sense if
you compare them to the /VX price rather
than the VIX itself.

Now, go spread the facts about volatility!

Thomas Preston is not a representative of

TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the
author and may not be reflective of those held by
TD Ameritrade, Inc. For more on the risks of trading
and trading options, see page 37, #1– 2.